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The Trump-Erdogan Clash and Turkish Financial Turbulence

August 15, 2018

Q1: What is behind the escalation in U.S-Turkish tensions?

A1: The continuing detention of U.S. pastor Andrew Brunson has escalated existing tensions in U.S.-Turkish relations while triggering a financial slump in Turkey. On August 1, President Donald Trump took the unprecedented step of imposing sanctions on the Turkish justice and interior ministers under the Magnitsky Act because of the Brunson case. Trump raised the stakes on August 10 by tweeting that he had “authorized a doubling of Tariffs on Steel and Aluminum with respect to Turkey.” He pointedly noted the impact of his action on the Turkish economy by saying that the Turkish lira was “sliding rapidly downward against our very strong Dollar!” Although State Department spokeswoman Heather Nauert stated on August 14 that “what is happening in Turkey goes far beyond the United States and the United States recent policies,” it is clear that there is a connection between the worsening of the relationship and Turkey’s financial downturn.

The descent into the current crisis has its origins in Trump’s conversation with Turkish President Recep Tayyip Erdogan on the sidelines of the NATO summit in Brussels on July 11 and the follow-up phone call between them three days later. The contacts apparently led Trump to believe that a discreet understanding had been achieved whereby Brunson would be released on July 18 when he appeared in a Turkish court for the third time. As part of his understanding of his part of the arrangement Trump called Israeli Prime Minister Benjamin Netanyahu on July 14 at Erdogan’s request to arrange for the release of a Turkish activist arrested for aiding Hamas. However, when the Turkish judge failed to release Brunson, Trump immediately denounced it as “a total disgrace” and, together with Vice President Mike Pence, a devout evangelical like Brunson, warned on July 26 that the United States would impose “large sanctions” on Turkey unless he was freed.

It is interesting to note that Erdogan had hinted at a possible deal on Brunson as far back as September 2017 when he said “You have one pastor as well. Give him [Fethullah Gulen, the Islamic cleric blamed by Ankara for the failed coup attempt in 2016] to us. Then we will try him [Brunson] and give him to you.” However, Gulen’s return was apparently not a part of the discreet negotiations prior to their breakdown and Turkish expectations reportedly centered on getting the administration to use its influence with respect to the expected U.S. Treasury fine on Halkbank, the Turkish public bank involved in evading Iranian sanctions, coupled with the return to Turkey of its former deputy general manager Mehmet Hakan Atilla, imprisoned because of his involvement in the case.

Two days before Trump’s move against the Turkish ministers, Erdogan denied that there had been a discussion involving a quid pro quo. After saying “We never said that we will give you Brunson. There was no such bargaining between us,” Erdogan added “You cannot force Turkey to retreat with sanctions.” Just before Trump’s announcement he further warned “We will not give credit to threatening language…It is not possible for us to accept the threatening language used by the evangelist, Zionist mentality in the U.S.”

However, even as he announced reciprocal sanctions on the U.S. interior secretary and attorney general on August 4, Erdogan chose to stress that Turkey did not want to be part of “a lose-lose game” as “carrying political and judicial disagreements to an economic dimension would harm both sides.” He claimed that “diplomatic channels were working intensely” and “an important part of the issues between the two sides would soon be left behind.” He was clearly referring to the meeting on the same day between Turkish Foreign Minister Mevlut Cavusoglu and Secretary of State Mike Pompeo—also an evangelical—in Singapore. With the Turkish media reporting that a preliminary agreement had been reached on Brunson, a Turkish delegation comprising nine senior officials from the Foreign, Justice and Finance Ministries then traveled to Washington for meetings at the State and Treasury Departments on August 8. They were surprised by the resolute stance on the part of their interlocutors who focused only on their demand for Brunson’s release within 24 hours while refraining from serious discussion of Turkish expectations. The predictable Turkish failure to comply with the virtual ultimatum set the stage for Trump’s tariff gambit on August 10, a very angry reaction from Erdogan, and financial turbulence in Turkey.

Q2: How is the sudden deterioration of the Trump-Erdogan relationship impacting the Turkish economic outlook?

A2: The Turkish lira (TRY) has lost more than 20 percent of its value since the beginning of August, and nearly 60 percent since January 1, earning the dubious honor of becoming the worst performing currency in 2018. Although it had been steadily losing value since the beginning of the year, there is little doubt that growing strains in the previously good Trump-Erdogan relationship accelerated the TRY’s sharp decline against the dollar during the past two weeks.

The TRY fell below the psychologically important threshold of 5 to 1 with the dollar on August 1 with the announcement of U.S. sanctions and continued its decline after the inconclusive meeting between Pompeo and Cavusoglu on August 3, Erdogan’s announcement of reciprocal sanctions on the U.S. treasury secretary and attorney general on August 4, and the USTR’s announcement on August 6 that Turkey’s eligibility to participate in the Generalized System of Preferences was under review. After a slight recovery following the reports of a “preliminary agreement” and an announcement of the Turkish delegation’s trip to Washington on August 7, it fell again after the failure of the talks to 5.44 on August 8. Trump’s decision to raise tariffs, which confirmed his readiness to inflict further economic pain on Turkey, pushed the TRY as high as 7.24 in Asian markets before settling at 6.42 on August 10. While the TRY was losing value, the benchmark interest rate jumped from 21.78 to 28.27 percent while ten-year government bonds rose to a record-high of 21.46 percent as of August 15. Five-year credit default swaps (CDS) climbed by nearly 200 to 543 basis points on August 12, its highest since 2008.

To be sure, Turkey’s current financial woes are the product of negative trends that have been clouding the economic picture for some time. Turkey’s large current account deficit, which has been increasingly financed with short-term funds as foreign direct investment tapered off, has been on course to reach 6 percent by the end of 2018. Portfolio investments, which have been falling since February, totaled only $79 million as of June, a fraction of the $17 billion that came in during the first half of 2017. The gross external debt stock rose to $466.66 billion, of which $269.2 billion is in dollars. The decline of the TRY added to the debt burden of the private sector, which owes $222.8 billion in long-term debt and $99.3 billion in short-term debt, with $133 billion of the long-term and $62 billion of the short-term debt in dollars. At the same time, even after the CBRT’s 500 basis point rate hike between April and June, there has not been a fall in the inflation rate or a major recovery in TRY. With the rapid depreciation of the TRY, combined with other negative factors, inflation rose to 15.85 percent in July and is expected to stay in double digits, as the CBRT’s decision to raise its earlier unrealistically low inflation expectations on July 31 confirms.

The vulnerabilities of the Turkish economy were under the close scrutiny of foreign investors before the Brunson crisis, especially after Erdogan’s comments in London during the election campaign that the CBRT would act in accordance with “signals given by the president.” These concerns had grown after the full transition to a presidential system following the June 24 election, the complete overhaul of the system around the presidency, and the appointment of Erdogan’s son-in-law Berat Albayrak as “economy czar” in charge of the combined Treasury and Finance Ministries. However, the crisis with Washington acted as a catalyst in heightening the ongoing debate beyond Turkey’s borders about the future of the Turkish economy.

Q3: What happens next?

A3: Erdogan has made it very clear that he does not intend to back down in order to end the dispute. In fact, through characteristically defiant rhetoric, he has chosen to intensify the crisis. On August 10 for example, he characterized the financial turmoil as a continuation of the 2013 Gezi Park protests and the July 2016 coup attempt directed at him and as “an economic war” on Turkey designed to spread “artificial waves of financial instability.” Addressing Trump in an op-ed in the New York Times on August 10, Erdogan warned that the U.S.-Turkey partnership could be “in jeopardy” unless the “United States starts respecting Turkey’s sovereignty” and that “the failure to reverse this trend of unilateralism and disrespect will require us to start looking for new friends and allies.” In a speech on the same day he said, “It is shame that you are changing a strategic partner in NATO with a pastor” soon after a phone conversation with Russian President Vladimir Putin about an expansion of the economic partnership.

On August 12, Erdogan said that there was an ongoing “operation to capture Turkey in all fields, from finance to politics, by neutralizing defense mechanisms of our country’s economy.” He directed another warning to Trump by saying “If you pressure us with dollars, we will search for other alternatives to carry out our work.” The following day he added, “Turkey is too great and important a country for its axis to be confined to a single region. In this spirit, we work to further deepen our cooperation with regional organizations such as BRICS, African Union and ASEAN.” He cautioned on August 14 that Turkey would “inflict costs on those who carry out the operation” as he announced Turks would boycott U.S. electronic products. He said “if they have iPhone, the other side has Samsung” while ordering retaliatory tariffs on U.S. cars, alcoholic drinks, and tobacco. On August 15, he hosted his close regional ally Qatar Emir Tamim al Thani who promised to steer $15 billion in FDI to Turkey.

With Trump equally defiant, the two countries remain locked in a stalemate. This was underlined by the absence of a breakthrough during the August 13 meeting between White House National Security Adviser John Bolton and Turkey's Ambassador to the United States Serdar Kilic, requested by the latter. A White House official confirmed to Reuters the following day that there was “no progress” and said that the administration was “extremely firm” on the Brunson issue. He added that without movement from the Turkish side “in the next few days or a week,” the United States could take “further action” with a new round of sanctions. On the same day, White House spokesperson Sarah Sanders commented that Trump had “a great deal of frustration on the fact that Pastor Brunson has not been released, as well as the fact that other U.S. citizens and employees of diplomatic facilities have not been released” while the White House Council of Economic Advisers Chairman Kevin Hassett commented “for the currency to drop 40 percent is a sign that there are a lot of economic fundamentals that are out of whack in that country.”

On August 15, Brunson’s appeal for release from house arrest was rejected, thus ensuring the continuation of the dispute between Turkey and its most important ally. This will inevitably exacerbate the higher risk factor Turkey was carrying compared to other emerging market countries. To be sure, recent steps by the CBRT and the Banking Regulation and Supervision Agency, including limiting currency swap transactions to prevent investors from accessing and shorting TRY, effectively increasing the interest rate to 19.25 percent by closing the one-week window for lenders and lowering reserve requirement ratios while vowing that the “Central Bank will provide all the liquidity the banks need,” have helped the TRY to recover to just below 6 to the dollar on August 15. However, in the absence of a resolution of the current crisis with the United States combined with tangible steps to address macroeconomic imbalances, including another significant interest rate hike, it may be difficult for Turkey to regain the confidence of outside investors who have been an essential part of its economic recovery since the last Turkish financial crisis in 2001, which necessitated a major IMF standby loan.

Bulent Aliriza is a senior associate and director of the Turkey Project at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Zeynep Yekeler is a research assistant with the CSIS Turkey Project.

Critical Questions is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).